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Using managerial revenue and cost estimates to value early stage real option investments

Sebastian Jaimungal () and Yuri Lawryshyn ()
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Sebastian Jaimungal: University of Toronto
Yuri Lawryshyn: University of Toronto

Annals of Operations Research, 2017, vol. 259, issue 1, 173-190

Abstract: Abstract Real options analysis is widely recognized as a superior method for valuing projects with managerial flexibilities. Yet, its adoption remains limited due to varied difficulties in its implementation. In this work, a real options approach that utilizes managerial cash-flow estimates to value early stage project investments is proposed. Our model is based on the assumption that managers can provide pessimistic, likely and optimistic sales and gross margin percent estimates. A market sector indicator is introduced, which is assumed to be correlated to a tradeable market index, which drives the project’s sales estimates. Another indicator, assumed partially correlated to the sales indicator drives the gross margin percent estimates. In this way a cash-flow process can be modelled that is partially correlated to a traded market index. This provides the mechanism for valuing real options of the cash-flow in a financially consistent manner. The method requires minimal subjective input of model parameters and is very easy to implement, based on simple managerial estimates.

Keywords: Investment analysis; Real options; Risk-neutral valuation; Cash-flow analysis; Project valuation (search for similar items in EconPapers)
Date: 2017
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Handle: RePEc:spr:annopr:v:259:y:2017:i:1:d:10.1007_s10479-016-2344-8